By Tiernan Ray

Shares of Microsoft (MSFT) are down 29 cents, or 1%, at $26.41, after Morgan Stanley’s Adam Holt today cut his rating on the shares to Equal Weight from Overweight, arguing the”base case” for the stock is $29 as corporate software of 10% per annum is offset by a lack of recovery in the PC market.

Holt actually starts out by making what sounds like a very strong case for the stock, with cash flow and the non-PC parts of the business supporting the current price:

MSFT is the cheapest stock in our coverage universe with a FCF yield of 17%, and Morgan Stanley’s “what’s in the price” tool suggests MSFT is pricing in negative EPS growth in three years, which we think is unlikely. If we strip out the Windows business altogether, the FCF yield is still double digits and the remaining company would be a double digit grower with a double digit FCF yield. So, clearly MSFT is already pricing in very low expectations for Windows and the PC market in general. The stock is too cheap relative to what is likely high single digit EPS growth longer term, particularly given the 3.5% dividend yield. Further, we think there is a powerful upgrade story around the Microsoft Business Division where we are as optimistic about the product set as we have ever been, while the execution in Server & Tools has been outstanding. Longer term, we are optimistic that MSFT can leverage its synergy across tablets, phones and the corporate desktops to provide a unified platform for application and content access, bolstered by its cloud services.

Nevertheless, he thinks Microsoft faces “a period over the next few quarters” where Windows 8 fails to “catalyze” sales of PCs, and where corporate PC growth, which has generally been stronger than consumers, tapers off, compounding the problem. He also thinks the boost from the debut of new versions of non-PC products, such as SQL Server, had now pretty much been appreciated by investors and won’t add much in coming quarters.

According to Holt, Microsoft’s remarks on Tuesday that it has sold 60 million licenses of Windows 8 since the software went on sale October 26th doesn’t ultimately mean much for the company because the PC market look is still poor:

According to NPD, the release of Win 8 has not reinvigorated PC demand and sales of Windows machines were down 11% YoY over the holiday period. NPD is just one snap shot of the market, though, and both European and Emerging market demand is better than US retail, and we believe sell-in is much better than sell-through. On that front, MSFT may do as many as 65-70M paid Windows units in the Dec. quarter, which is well ahead of consensus expectations in the 60-62M unit range, although ultimately, the 65-70M reflects sell in, pent up demand and preorders and the market will trend towards sell through over time. Given the continued sluggishness in the market in aggregate, we expect total PC units to be flat to down low single digits in CY13 and CY14. While MSFT’s revenue has disaggregated from the PC market, the stock still tends to track it to a degree.

Corporate PC growth, moreover, is slowing, Holt thinks, based on Microsoft’s recent remarks tag “over 60% of enterprise desktops worldwide were now running Windows 7 as the impending end of life for Windows XP support in April 2014 and Win 7 corporate upgrade cycle have provided a meaningful tailwind to the corporate PC cycle.”

He adds, “Supply chain data points have also indicated softening of corporate PC demand due to macro uncertainty, tablet cannibalization and some inventory destocking.” Holt expects some corporate buying of Microsoft’s Surface tablet computer, but not enough to keep him from cutting his corporate PC growth estimate to .25% from 5%.

Holt outlines a number of things that could in future improve the Windows outlook, including more notebook computers with touch capabilities, more apps available for version of Windows that runs on ARM Holdings (ARMH)-compatible chips, and better pricing and battery life for the “Surface Pro” version of Surface that runs on Intel (INTC) processors.

Holt cut his revenue estimate this year to $79.9 billion and EPS of $2.83 from a prior $83.52 billion and $3.01 per share.

He thinks two things could possibly help the stock in the immediate future. One is porting Microsoft Office to Apple’a (AAPL) iPad, which might bring in $1.3 billion in new revenue. Another is if congress were to enact legislation to let the company bring back some of its $50 billion in overseas cash. But he’s not holding his breath on that score.

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There are 7 comments

JANUARY 10, 2013 1:46 P.M.

Baupost wrote:

Thanks,
We just started buying again today at 6.5 x EBITDA

$26.32 a share is a steal

JANUARY 10, 2013 1:55 P.M.

Alex wrote:

So they're essentially saying it's a great investment, but since we are in the business of predicting short term price movements, we don't like it; at least this is appropriately titled "Tech Trader" - maybe one day Barron's will have a blog for actual investors???

JANUARY 10, 2013 2:11 P.M.

Bob wrote:

What he is saying is that Morgan is going to start accumulating at these levels at
the expense of retail customers who follow his guidance.

JANUARY 10, 2013 2:22 P.M.

blake wrote:

Windows 8 is doing great, of course there are those who find it strange and don't like change. But corp is not among those.

Every IT dept knows full well that the desktop is a single click away and windows 8 offers them more and easier control so it is something they will shift to over time.

The consumer sales will pick up faster as more and more new touch designed machines hit the retail floors. Right now it is hard to buy real WIndows 8 PCs, most are just rebadged windows7 laptops and we the public are not stupid.

So with intels new range of super low power but high performance chips enroute to market. and with the CEO of Lenovo openly and publicly stating the entire OEM/ ODM industry under estimated the consumer demand for touch based PCs they are all ramping up screen production and hurrying to correct the error.

So Windows 8 not doing well? No Windows 8 is doing as well as 7 did and has lots of more to speed up as supply and product improves.

If the PC market is defined to include all oersonnel computers and not just WQintel then it is growing faster then ever and Windows 8 and Windows Phone 8 will be really huge successes. Nokia is just the beginning.

JANUARY 11, 2013 12:13 A.M.

LOLOL wrote:

Windows phone 7 failed hard so they put the windows phone interface on their desktop OS? In a weak economy and a saturated pc market Microsoft has decided to give people a reason not to buy their OS. LOL. Microsoft is in the process of destroying it's flagship product in the hopes that it will help them sell a few more phones.

About Tech Trader Daily

Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.